A sharp rise in U.S. Treasury yields could send tremors to every corner of the globe, according to one of the European Union's scenarios for its forthcoming stress tests for the region's banks.
As part of its rigorous stress testing of European banks, the European Banking Authority (EBA) - the regulatory agency of the European Union - has detailed a range of adverse scenarios which will be used to assess impacts on these banks, including dwindling growth, stock market and house price crashes, soaring unemployment and currency crises.
The tests - which are much tougher than similar assessments by the EBA back in 2011 - are designed to test how resilient bank capital reserves are to economic shocks.
Tuesday's release is part of a process to repair the balance sheets of European banks after the financial crisis of 2008 and sovereign debt troubles of 2011. An asset quality review started in earnest last November with the bloc's regulator selecting the 128 banks that would come under its portfolio. Phase 2 came into action last month and will see the execution of these rigid stress tests.
The stress tests had been viewed in the market as potentially negative headwinds for European banks this year. Analysts gave them a cautious welcome.
"The assumptions for the adverse scenario do not look particularly aggressive at first glance. Our banks analysts see limited capital shortfall for the overall sector and for those that may have to raise capital, we think that it can be manageable," EmmanuelCau, equity market strategist at J.P. Morgan, told CNBC.
European banks that show they are vulnerable under these imagined scenarios will be faced with the prospect of having to raise more capital or selling assets.
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The gloomiest of the scenarios, and the most pertinent threat to banking sector stability, is a situation in which global bond yields rise and trigger an abrupt reversal in risk appetite, it said. This would start with a rise in U.S. long-term interest rates. In this hypothetical scenario this initial rise would be 100 basis points above its baseline, it said, then increasing gradually to 250 basis points by the last quarter of 2014, before leveling off in 2015.
Consequently, the document, released on Tuesday, predicts a "market tantrum" with sizable capital outflows in emerging markets that would lead to some being excluded from international capital markets. Exports from the European Union from these regions would be hit, according to the EBA, putting "significant downward pressure" on GDP (gross domestic product) growth as a result. The estimates show that consumer prices in the European Union would fail to rise in 2016, stirring potential deflation, and unemployment would hit 13 percent by the same year. Meanwhile, the Union would show negative growth of 1.4 percent next year, it said.
"The estimated negative impact of the various financial and real shocks on economic activity worldwide is substantial. For most advanced economies, including Japan and the U.S., the scenario results in a negative response of gross domestic product (GDP) ranging between 5-6 percent in cumulative terms compared to the baseline," the EBA said in the report.
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"In some of the more fragile (emerging market economies), the adverse impact on GDP growth is even stronger, with a cumulative decline of up to 10 percent."
The research ranks the sovereign bond shocks to each individual country in Europe if U.S. yields jump. In Germany, long-term bonds yields would quickly spike by 316 basis points from their baseline scenario, meaning the German government would have to stump up more cash to finance its debts.
"The global re-pricing of asset prices has effects well beyond sovereign debt markets," it said. "The re-pricing of risk affects in particular stock prices."
These stock prices would decline by approximately 18-19 percent on average in the euro area and the EU as a whole, it said. The U.S. would be the first hit with a deviation of nearly 30 percent in this scenario.
Emerging European countries would be badly hit, it said. Hungary and Poland are assumed to experience a 25 percent depreciation of their currency, while the Czech Republic, Croatia and Romania would face instead a 15 percent shock.
House prices are also severely hit with its estimates showing that U.K prices could dip 15 percent next year from a baseline scenario, whilst French prices would fall nearly 17 percent and prices in Germany would slip 12.5 percent.
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